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Following the strong performance of gold over the last few years, investors worldwide have started to include gold as a new asset class for their investment.
Last year, gold price surged 24.6% to close at US$1,096 (RM3,748.32) per ounce after breaking through the US$1,000 psychological resistance level. 2009 marked the 9th uninterrupted gain in gold price. Prior to that gold price fell for 20 years.
The supply
A quick look at the supply side equation shows that between 2004-2008, 60% of the gold came from mines, 28% from recycling of gold from scrap and another 12% from sales by central banks (see Chart 1).
When gold price was still falling prior to 2001, gold output from mines continued to rise from about 1,200 tonnes in 1980 to a high exceeding 2,500 tonnes in 2001. Since then, gold output fell gradually despite strong recovery of gold price (see Chart 2).
The exhaustion of old mines was not replaced by new capacity partly due to limited investment in the past when gold price was low. For the time being there is still no indication that mine production will increase from new mines or marginal mines.
South Africa had always been remembered as the world’s largest gold producer. Unfortunately due to exhaustion of its reserves, China overtook South Africa to become the leading gold producer in 2008. The other prominent producers in order are USA, Australia, Peru, Russia, Canada and our neighbour Indonesia.
The demand
68% of gold was used in jewellery with the balance of 18% and 13% going to investment and industry purposes, respectively. India is the world’s largest consumer of gold jewellery. Affluent Chinese pushed China to the number two position in retail gold market, overtaking the US in 2007. As a group, Middle East is also a prominent jewellery consumer.
Jewellery demand fell last two years, partly due to hike in price and partly due to economic conditions. The fall in demand in 2008 was about 9% but that widened to 22% estimated by Credit Suisse in its January report.
Gold above ground
According to the World Gold Council, the total amount of gold that has been mined is estimated at 163,000 tonnes. Based on the current value of US$1,100 per ounce, it is worth about US$6 trillion which is 2/5th the size of US economy and double the size of Japan economy (Note 1kg= 32.15 troy oz). As expected, most of this gold is already made into jewellery and held by individuals. That accounts for slightly more than half of gold. The balance is used in industrial applications, held for investment and in the vaults of central banks.
Central banks’ holding
Collectively central banks hold about 29,000 tonnes worth about US$1 trillion. The single largest holder of gold is by the US, about 8,200 tonnes. Countries having between 2,000-3,300 tonnes include Germany, France and Italy. The International Monetary Fund (IMF) was the world’s third largest holder of gold with about 3,200 tonnes at end of 2008.
In terms of percentage of external reserves, gold accounts for 80% of US foreign reserves. Many developed countries have more than 50% of the external reserves kept in gold and they are Portugal, Greece, Germany, France, Italy, Austria and the Netherlands. It should be noted that although many developed countries have a large proportion of their foreign reserve in the form of gold, their external reserves as a percentage of GDP are relatively low.
On the contrary, most of the developing countries which have amassed a substantial amount of current account surplus, mainly through exports, do not invest in gold. Most of them do not have more than 2% of their foreign reserves in gold and that includes Japan. The reason is simple. The rising external reserves earned by many developing countries especially those from Asia were made during the past 10-30 years. During that period, gold price did not perform and there was no reason to put money in non-performing asset class.
Central banks were net sellers
In fact, many central banks were trying to pare down their holdings in gold after gold price fell from its peak at US$850 an ounce in 1980. For the past 20 years central banks sold about 8,000 tonnes of gold or about 400 tonnes per year, equivalent to 16% of yearly mine production. The persistent disposals by central banks pressed down gold price to a low of US$252 in 1999 (see Chart 3). Aggressive sellers of gold were Switzerland and UK. UK, under her finance minister then and present prime minister, Gordon Brown, sold most of the gold around the bottom which is commonly coined as Brown’s Bottom to denote the poor timing.
The excessive selling by central banks depressed gold price for a long period. The 14 European central banks subsequently agreed to limit their disposals to 400 tonnes a year in September 1999. The accord was raised to 500 tonnes in 2004 but again reduced to 400 tonnes per annum in September 2009. If not for the curtailment by central banks, gold price will probably dip below US$200 and it may not recover as fast.
After the recovery of gold price from 2001, central banks were still net sellers. Between 2004 and 2008, the disposal by central banks accounted for circa 12% of gold supply.
Now central banks turned net buyers
After nine years of persistent gold price increase, sentiment has started to turn bullish. For the first time since 1988, central banks were net buyers last year. India bought 200 tonnes of gold from the IMF early November worth US$6.7 billion. The board of IMF has approved to dispose of 1/8 of IMF’s gold reserves or 403 tonnes to strengthen its balance sheet. Other buyers of IMF gold were Russia, Sri Lanka and Mauritius. China and Japan were also reported to increase their holdings of gold.
China has been increasing her gold holdings but it is only about 2% of her international reserves, falling short of the 5% target. China purchase of gold is via domestic production and it is not active in the international market yet.
With the renewed confidence following gold price recovery, more and more central banks are now convinced to increase their gold holdings which is currently at very low levels vis-a-vis their Western counterparts.
Central banks now want to diversify their reserve base away from the US$. It will look good on them if gold price continues to appreciate. This is contrast from 20 years ago when gold price was falling and central banks looked dumb for keeping depreciating asset. Even if gold price weakens in the future, it is still all right for emerging market central banks as gold only accounts for a small portion of their external reserves.
Central banks — main price anchor
While developed countries may continue to sell their gold holdings, purchases by reserve-rich countries will be able to overcome the selling pressure. European central banks only managed to dispose of 75% of their quota in 2004-2009 and they are likely to sell less than the targeted amount over the next five years.
The purchase of 200 tonnes of gold by the Indian government from IMF provided the additional boost to gold price. When gold price weakened to around US$1,000 level, purchases by central banks will be more aggressive and the remaining 200 tonnes of gold ear-marked to be disposed of are likely to be snapped up.
Gold ETF is a main player
Other than central banks, a flood of money into commodity funds including gold ETF is an important factor supporting gold price last year, especially during the 1st quarter of 2009. Institution and retail purchases of ETF, such as ETF SPDR, became a self-fulfilling prophecy to move gold price higher last year. One disturbing sign is that there are profit-taking activities, especially among institutional investors when gold price headed towards US$1,200. Investors’ action this year and their unity are crucial to determine how the gold price will go.
Gold as an asset class
Gold has done poorly in the 1980s and 1990s both as an inflation hedge as well as preservation of value. Including the recent appreciation, gold probably yielded 2% per annum (pa) over the past 40 years. It is only when gold has started to show its shine again recently that people started to regard gold as a good hedge for inflation. So far, there are no gurus encouraging investors to buy gold for wealth creation. Gold is definitely not suitable for the faint-hearted conservative investors as its price is volatile. In a way it is a high-risk investment. This can be seen from the standard deviation of return which is similar to that of world stocks at about 15%-17% over the past 20 years.
Weaker US$ good for gold
Consensus is that gold price will appreciate over the immediate future as the US$ is likely to depreciate further due to its high budget and trade deficits. This is generally true for gold and most commodities including crude oil. There are also instances where gold moves in the opposite direction of the US$. While the US$ may be on the downtrend in the long run, being the international reserve currency, it will not fall in a straight line as other central banks do not want the US$ to depreciate excessively. We will see regular rebound of the US$.
Although a weaker US$ may help to lift the price of gold, in ringgit terms, the appreciation of ringgit will take away some of the gains.
Pure capital gain
From the investment point of view, gold is the opposite of fixed deposit which only provides fixed income but no capital appreciation. Gold on the other hand only provides capital gain (or loss) but no income. Most investment assets provide certain forms of income — bank deposits provide interest income, shares provide dividend incomes and properties provide rental incomes. In this way, the only hope of investing in gold is for capital gain. As capital gain is not certain, one can call it speculative gain. If one buys a kilo of gold, it will remain a kilo after ten years. The only difference ten years later is the price. On the other hand, if one invests in a growth stock, it will most likely grow into a bigger company after ten years. In this way, investment in stocks has better chances of price appreciation. This is on top of the regular dividend an investor will receive from the company.
While some may postulate the limited supply of gold as the reason for long-term holding in gold, the fact is that gold is also very much sentiment-driven which may come and go depending on the situation.
In view of the volatile nature of its behaviour and in the absence of regular income, the strategy of gold investment should not be buy-and-hold. A shorter-term approach with trading mentality to take profit should be adopted for gold investment.
Price outlook
Predicting how the price of gold will behave is not easy. There are many experts doing it on a full-time basis and many still get it wrong.
Fundamentally, mine supply is presently more than enough to meet the combined demand from jewellery and industrial uses, both of which have fallen after the recent financial crisis. On top of the surplus, the supply from recycle scrap gold is expected to increase further this year after a 16% jump in supply last year and 24% surge in 2008 as people cashed in on the high gold price. Net central bank purchases will help to take up some of the slack in demand. The balance will very much depend on purchases from ETFs.
As demand from ETF could be very sentiment-driven, depending on the overall market conditions and price level, the action of ETF will have a strong influence on the direction of gold price this year. In order for gold price to scale higher, it needs to consolidate after the sharp appreciation during the last two months so that new investors will garner the courage to jump onto the bandwagon. The same psychology also applies to central bankers. Gold is likely to see better support around US$1,000 and perhaps that is the good entry level for those who believe in gold.
The trend of the US$ also has its impact. While the US$ may depreciate further, there is also a strong likelihood the US$ will stage a strong technical rebound this year which may last for 3-9 months. When the US$ rebounds, gold price will be under pressure.
Investment in gold should also be seen as a diversification strategy where a small portion is allocated. It should not replace our traditional asset class like bonds, stocks and properties.
Ang has 20 years’ experience in research and investment. He is currently the chief investment officer of Phillip Capital Management Sdn Bhd.
This article appeared in The Edge Financial Daily, January 25, 2010.
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